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Understanding Investment Appeal For Businesses

Invest appraisal is a set of techniques to weigh up the potential of various investment/projects which will always come up in Business Studies A2 BUSS 3.

There are three quantitative techniques:

  • Payback - Time taken to recoup initial investment.
  • Average Rate of Return (ARR) - Percentage profit on the investment.
  • Net Present Value (NPV) - Profit of the investment at current values.
Payback is the time taken to recoup initial investment.

To work out payback of a project, you will need to use the following equation:
Payback = Y + (A / B)
Where Y is the number of years before the final payback year.
Where A is the remaining money needed to payback the cost of the project at the start of the payback year.
Where B is the total amount paid by in the payback year.

That will sound confusing so here is an example where we can work out payback:

Project A (in £'000s)

  • Year 0 - (500)  
  • Year 1 - 180
  • Year 2 - 180
  • Year 3 - 180
To work out the payback, we can need to see how long it takes to recover the initial cost of £500,000. Using the formula, this is 2 + (140 / 180) = 2.78 years.

Average Rate of Return (ARR) 
The average rate of return (ARR) is the percentage profit on the investment.

To work out ARR, you will need to use the following equation:
Average Rate of Return = Average Annual Profit / Initial Cost
 Project A (in £'000s)

  • Year 0 - (500)  
  • Year 1 - 180
  • Year 2 - 180
  • Year 3 - 180
  • Year 4 - 180
Remember to include the initial cost when working out average annual profit!
This makes the average annual profit of project A = (180 + 180 + 180 + 180 - 500) / 4 = 55
Therefore, ARR is 55 / 500 = 11%. 
We can compare ARR to other sources of finance such as banks where the interest rate is of around 3%. This means the project is more profitable than the opportunity costs.

Net Profit Value (NPV) 
Net profit value is the profit of the investment at current values.

To work out NPV, you will need to use the discount factors for each year's profit. In the BUSS 3 exam, you will be given a set of discount factors to use. NPV is a forecast of the rate at which money loses value. It reflects:
  • Inflation.
  • Opportunity cost of saving.
We can use a discount factor on project A to see how much money we make from the project taking into consideration the NPV of money. We will use a discount factor of 6%:

 Project A (in £'000s)

  • Year 0 - (500) x 1.00 = (500)  
  • Year 1 - 180 x 0.94 = 169.2
  • Year 2 - 180 x 0.89 = 160.2
  • Year 3 - 180 x 0.84 = 151.2
  • Year 4 - 180 x 0.79 = 142.2
NPV (sum of all blue numbers) = £122,800

What Qualitative Factors Might Be Important For Investment Appeal?
  • Risk associated with products (e.g. how likely they are to deliver forecast profits?).
  • Reliability of forecasts: have there been any window dressing?
  • Cash flow vs profit (getting the money back fast or longer term profit which relates to the financial objectives of the business).
  • Sources of finance - how do they raise the initial investment?
  • Fit with company's aims or culture (if it doesn't fit with company's aims or culture you might be persuaded not to do the project).
  • Market conditions such as competitors, customers and the economy (no-one wants to invest in a depression because there is no confidence and will be a risky investment to regain control again).
For Business Studies, remember to read the case study for clues on these points. If you haven't got the information, suggest that the company should show the information and then make a judgement using the information you have.

About Will Green

A student in England studying Automotive Engineering with Motorsport, Will created Ask Will Online back in 2010 to help students revise and bloggers make money. You can follow AskWillOnline via @AskWillOnline.

4 comments so far:

  1. thanks for posting - I always forget these calculations - got the exam on Wednesday ugh.

  2. Is it me or is there a mistake in the first payback section. Where is year 1. Is year 1 meant to contain the value 140? Therefore making the equation [ 2 + (140 / 180) = 2.78 years.]?

    1. There was a mistake but not a serious one (just changed year 2 to year 1 and so on). The £140 in the calculation came from the amount needed to be paid off before the final year. The final year that will pay the (500) off is year 3. Therefore year 1 + year 2 = £360. 500 - 360 = 140. 140/180 = time in year 3 to pay off remaining £140 left. Hope this helps.

  3. Can someone explain on the NPV where 0.94, 0.89, 0.84 and 0.79 came from please and how to work them out!!?? also I never understood payback until now, so thanks for that, EXTREMELY appreciated!